NATIONAL QUALIFICATIONS CURRICULUM SUPPORT
Economics
Microeconomics
[INTERMEDIATE 2;
HIGHER]
Martin Duguid
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Acknowledgement
Learning and Teaching Scotland gratefully acknowledge this contribution to the National
Qualifications support programme for Economics.
© Learning and Teaching Scotland 2005
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Contents
Unit 1: Microeconomics
Topic 1: The basic economic problem
Topic 2: Demand
Topic 3: Supply
Topic 4: The operation of markets
Topic 5: Types of market (for Higher only)
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Unit 1
Topic 1: The Basic Economic Problem
1
Scarcity
1.1
The basic economic problem is scarcity. In economics scarcity means
that there are not enough resources to produce all the goods and
services which consumers want. Scarcity arises because human wants
for goods and services are unlimited but the resources required to
produce them are limited.
1.2
Scarce goods and free goods. Scarce goods, also called economic
goods, are those which have a price i.e. something has to be sacrificed
to obtain them. Free goods are those goods of which there is enough to
satisfy everyone’s wants e.g. fresh air, sea water. Free goods have no
price. All scarce goods have an opportunity cost whereas free goods do
not.
1.3
Scarcity is not the same as shortage.
• A shortage is when the demand for a product is greater than its
supply.
• Scarcity is when wants for a product are greater than its supply.
Demand means what consumers want and can afford to buy. Therefore
if there is enough of a product to meet the demand of those consumers
who want and can afford to pay the prevailing price there is no
shortage. However the product will remain scarce because of all those
consumers who want the product but cannot afford to pay the price.
2
Choice and opportunity cost
2.1
Because of the problem of scarcity it follows that choices have to be
made. Consumers must choose what to buy out of their limited incomes.
Producers must choose what to produce with their limited resources.
Governments must choose what services to provide out of their limited
tax revenues.
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2.2
Every choice involves a sacrifice and this sacrifice is called opportunity
cost. Opportunity cost is the sacrifice of the next best alternative
choice. For a consumer the opportunity cost o f choosing a product is the
next item on his/her scale of preference. For a producer the opportunity
cost of producing a good is the next most profitable product which
could have been produced with the resources used. For a government
the opportunity cost of providing a service is the next best service
which it could have provided with the resources used.
2.3
In economics we assume that people are rational, i.e. when faced with a
choice they will always choose the alternative that will give them the
greatest satisfaction. This involves weighing up all the alternatives and
then choosing the one that has the lowest opportunity cost.
3
Resources: factors of production
3.1
Resources may be classified as natural, human or man -made. They are
sometimes called factors of production and are then classified as land,
labour, capital and enterprise.
3.2
Land refers to all the gifts of nature and includes not only land itself,
but also all the minerals in and on the land, the sea and everything in
the sea, the air, sunlight, etc.
3.3
Labour refers to any human effort (manual or mental), which is directed
to the production of goods or services.
3.4
Capital refers to those man-made resources which are used to produce
goods or services. Capital may be categorised as ind ustrial, social,
private or financial.
• Industrial capital is used by firms, e.g. factories, offices, plant and
machinery, tools, vehicles.
• Social capital belongs to the whole community, e.g. schools,
hospitals, roads.
• Private capital belongs to individuals, e.g. houses.
• Financial capital is money waiting to be used to buy capital goods.
When capital goods are bought this is called investment. (Note the
difference between saving and investment!)
3.5
Enterprise refers to the decision making and risk taking of
entrepreneurs. The entrepreneur decides how many of each factor is to
be used, how they are to be combined to make the most profit and how
the work should be done. He or she also bears the risks caused by
business uncertainties. An entrepreneur is an organiser and a risk taker.
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Mobility of resources
4.1
Modern industrial economies are dynamic. This means that they are in a
continual state of change. Changing consumer demands and changing
production methods mean that some industries will be gr owing, e.g.
electronics, finance while others are declining, e.g. coal, shipbuilding.
In such a world there is a need for resources to be mobile – to be able to
change their location or their use. Resources which cannot change
either their location or their use run the risk of becoming unemployed.
4.2
Factor or resource mobility is the speed and ease with which a resource
can move from place to place (geographical mobility) or can change
use (occupational mobility).
4.3
In practice there are obstacles to factor mobility and to ensure that
resources are used efficiently these obstacles need to reduced.
4.4
Land tends to be geographically immobile. Its mineral wealth and the
crops it produces are commonly transported from one area to another
but the great majority of land is used where it is. For this reason,
attention is focused not so much on where it might be used as on how.
4.5
People may become geographically and occupationally immobile. Many
factors influence people’s mobility. Willingness to move elsewhere is
determined largely by age and by family and cultural ties. Willingness
and ability to do another type of job is closely linked to age, edu cation
and training.
4.6
Capital has varying degrees of mobility. Some capital is highly special ised. As a result it is difficult to adapt it to other uses. Power stations
and swimming pools are examples, as also are screwdrivers and
staplers. The geographical mobility of capital is deter mined largely by
its size and weight. Money capital is much more mob ile. It can be
moved about the world quickly and cheaply by electronic means.
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Economic efficiency
5.1
All countries have the problem of scarce resources and so should find
ways of making best use of them. Best use of resources is called
economic efficiency.
5.2
Economic efficiency in the use of a country’s resources is achieved
when the following three conditions are met:
(a)
when technical efficiency is achieved, i.e. when products are
produced at minimum unit cost, in other words when the fewest
necessary resources are used to produce each product.
Example
In building a bridge, using the least amount of steel while ensuring the
bridge will not collapse. Building a bridge strong enough to take 1000 ton lorries would be wasting steel, which could be used for making
other products.
(b)
when allocative efficiency is achieved, i.e. when resources are
allocated (used) to produce those goods and services which
consumers most want.
Example
One hundred bridges could be built over the River Don in Aberd een in a
technically efficient way, but this would be a wasteful use of resources
if consumers do not want 100 bridges. The resources could have been
used to make products which consumers want more.
(c)
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when all resources are employed. Idle resources will result in
lost output.
Equity
Equity concerns social justice or fairness. The aim of economic
efficiency can conflict with the aim of equity, e.g. a country with a
free-market economy could be achieving economic efficiency by
satisfying many of the wants of a few rich people at the expense of a
large number of poor people.
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7
Economic systems
7.1
All nations face the problem of scarcity, i.e. they have insufficient
resources to produce all the goods and services which their citizens
need and want. Three basic questions have to be addressed:
• What goods and services will be produced?
• How will these goods and services be produced? This means who
will do the production and which methods of production will be
used.
• To whom will the goods and services be distributed? This means
who will consume the goods and services after they been produced –
how will it be decided who receives them.
7.2
To address these questions a nation needs an economic system. There
are three different economic systems: the command or planned
economy, the market economy, and the mixed economy. Each has
different ways of allocating resources and of distributing goods and
services to consumers.
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The command or planned economy
8.1
All decisions about resource allocation are made by government. The
government owns the resources and directs them into the production of
the goods and services decided on. This system is based on the principle
of equity. This was the type of economic system which used to exist in
the communist countries of Eastern Europe.
8.2
A command economy answers the three questions in the following
ways:
• What to produce? – government planners estimate what their
population need. They fix the quantity of each good to be produced.
• How to produce? – government sets quotas for each factory and
decides how many resources should be employed in producing the
goods.
• For whom to produce? – prices and incomes are controlled so that
each citizen has an almost equal entitlement to what has been
produced.
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Free-market economy
9.1
The features of a market economy are:
• Resources are owned by private individuals.
• Producers are free to produce what they wish.
• Consumers have consumer sovereignty (literally meaning the
consumer is king) and rule the market, i .e. the freedom of consumers
to decide what to buy influences what producers produce.
• Decisions are made on the basis of self-interest. Producers aim to
maximise profit. Consumers aim to maximise value for money.
• Competition exists between producers and between consumers.
• Resources are allocated by the price mechanism. Price acts as a
signal to producers. Products which consumers demand will rise in
price thus encouraging producers to supply them. Producers will
need more resources. They will attract them by offering higher
incomes to those who own them. Falling demand for products will
result in lower prices and lower rewards to owners of resources so
that they will then be encouraged to move their resources to where
the rewards are greater.
9.2
A market economy answers the three questions as follows:
• What to produce is decided by consumers.
• How to produce is decided by producers using the most efficient
methods of production in order to keep down cost so that they can
compete and maximise profit.
• To whom products are distributed is decided by the buying power
of those consumers who earn the highest incomes from the resources
which they own.
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The mixed economy
In this system there is a private sector and a public sector. In the private
sector the price mechanism allocates resources but the public sector, i.e.
government, intervenes when the private sector fails to produce in an
efficient way the goods and services which consumers want. In practice,
all economies are mixed – what varies is the degree of mix. Some are
planned rather than free, e.g. China, while others are more free than
planned, e.g. the UK.
Please note that Economic Systems is dealt with in more detail in Topic
3, The Role of Government in the Economy of Unit 2, The UK Economy.
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Production Possibility Curves (PPC)
11.1 Production possibility curves can be drawn (in theory) for a country or
firm to show the possible combinations of goods that can be produced.
11.2
Capital goods
Consumer goods
On the diagram above, A is the maximum amount of consumer goods
that a country could produce if all resources were devoted to their
production. B is the maximum amount of capital goods that could be
produced. The production possibility curve joins all the possible
maximum combinations of consumer and capital goods. This maximum
output is called the country’s potential output.
11.3 Points on the curve are possible if all existing resources are being fully
and efficiently employed, i.e. if resources are being used in a
technically efficient way. If the economy is producing at a point inside
the curve then it is producing less than it could. This could be because
some resources are unemployed, or because some resources are being
used inefficiently. Points outside the curve are not pos sible because the
economy does not have the productive capacity. Given that any point on
the curve represents a technically efficient use of resources, an
economy still has to make the decision about which combination of
goods to produce. Remember that to use resources in an economically
efficient way, the combination chosen must be that which satisfies most
wants.
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11.4 A production possibility curve can be used to show the opportunity cost
of producing a product, e.g. the opportunity cost of producing OD
consumer goods is EB capital goods. The resources required to produce
OD could have been used to produce more capital goods, i.e. EB.
Capital goods
Consumer goods
11.5 A production possibility curve (PPC) can also show the opportunity
cost of a change in production, e.g. the opportunity cost of increasing
the production of consumer goods from OD to OF is EG capital goods.
Capital goods
Consumer goods
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11.6 The usual PPC curves outwards from the origin because the opportunity
cost of producing one good usually increases as mor e of it is produced.
This is because more resources are required to produce each extra unit.
Notice that as more consumer goods are produced the opportunity cost
in terms of lost capital goods increases.
Capital goods
Consumer goods
11.7 If an economy’s productive capacity increases, the PPC will move
outwards and more of both goods can be produced. This is known as
economic growth. This would result from an increase in the quantity of
a country’s resources, e.g. discovery of North Sea oil; an advance in
technology, e.g. the invention of the microchip; or an increase in the
efficiency of resources, e.g. training of workers.
Capital goods
Consumer goods
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Topic 2: Demand
1
Consumer behaviour
1.1
Consumers gain satisfaction from consuming goods and services.
Economists call this satisfaction utility. The utility gained from
consuming a product is difficult to measure accurately but three
possible ways of measuring it are by noting:
• how people react when they are consuming
• how much of the product people consume
• the price that people are willing to pay for it.
Note that none of these measures is totally reliable, but the third is the
most commonly used.
1.2
Total utility is the total satisfaction gained from consuming a product in
a period of time. Marginal utility is the satisfact ion gained from
consuming an extra unit of a product. Total utility, then, is the total of
the marginal utilities gained from each unit consumed.
1.3
Diminishing marginal utility. As a person consumes more of a good or
service in a certain period of time, the utility gained from each extra
unit (the marginal utility (MU)) decreases. Total utility will continue to
increase, although at a decreasing rate, until a maximum is reached. At
this point there is no further satisfaction to be gained from consuming
more of the product. Marginal utility will be zero.
Example
Using the price the consumer is prepared to pay as a measure of utility:
Pints of beer (per night)
First
Second
Third
Fourth
Marginal utility
£2.00
£1.80
£1.50
£1.10
Total utility
£2.00
£3.80
£5.30
£6.40
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This is the same as saying that:
• if price were £2.00 the consumer would be willing to buy
because he gets £2 worth of utility
• if price were £1.80 the consumer would be willing to buy
because he gets £2 worth of utility from the first pint and
worth from the second
• if price were £1.50 the consumer would be willing to buy
• if price were £1.10 the consumer would be willing to buy
Marginal utility of pints of beer
1.4
2 pints
£1.80’s
3 pints
4 pints.
Total utility of beer consumed
The information in 1.3 can be converted into a demand schedule:
Price
£2.00
£1.80
£1.50
£1.10
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1 pint
Quantity demanded
per night (in pints)
1
2
3
4
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1.5
The same information can be shown on a graph as a demand curve.
Demand for beer
Note that the demand curve and the marginal utilit y curve you drew in
para. 1.3 are the same curve.
1.6
Consumer surplus is the difference between how much a consumer
would be prepared to pay and what is actually paid, e.g. if beer were
£1.80 per pint, 2 pints would be bought. The consumer was prepared to
pay £2 for the first pint so he gets 20p of utility free i.e. he gets a
consumer surplus of 20p. If the price were £1.50, he would gain
consumer surplus of 80p (50p + 30p) of utility free.
1.7
Rational consumer behaviour. Economists assume that consumers act
in a rational way i.e. they spend their money in the way that gains them
maximum utility or, in plain English, best value for money. Of course,
in practice, this does not always happen. Several factors may prevent
this, e.g.:
• imperfect knowledge of the product or of rival products
• the actions of other people (both positive and negative)
• lack of self-control – the consumption of some addictive products
may be involuntary.
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Assuming rational behaviour, a consumer will achieve maximum utility
in the spending of their income when the marginal utility (MU) per p,
spent on the last unit of each good is equal, i.e. when:
MU of last unit of good A
MU of last unit of B
=
MU of last unit of C
=
Price of A
Price of B
Price of C
Example
A student has £10 to spend one day on her lunch. There is only beer and
sandwiches available. She gives a score out of 100 for the utility she
thinks she would gain from each pint and each sandwich. Beer costs £1
per pint and sandwiches cost £1 each. How should she spend her £10 in
order to gain maximum satisfaction? See the following table.
Beer
(pints)
Marginal
utility
1
2
3
4
5
6
7
8
9
10
100
90
80
70
60
50
40
30
20
10
Marginal
utility per
p
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
Sandwiches
Marginal
utility
1
2
3
4
5
6
7
8
9
10
50
45
40
35
30
25
20
15
10
5
Marginal
utility per
p
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
At 7 pints of beer and 3 sandwiches, satisfaction is maximised. If she
were to buy an eighth pint of beer she would ga in 0.3 units of utility per
p, but this would have an opportunity cost of 0.4 units of utility per p
from the third sandwich given up. If a fourth sandwich were bought,
0.35 units of utility would be gained but at an opportunity cost of 0.4
units of utility from the seventh pint of beer given up.
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Demand
2.1
Definition. Demand (sometimes called effective demand) is the
quantity of a good or service which consumers are willing and able to
buy at a particular price in a certain period of time.
2.2
Individual demand and market demand. Individual demand refers to
the demand of an individual consumer for a product. Market demand is
the sum of all individual consumers’ demand for a product, i.e. total
demand.
2.3
The Law of Demand states that the demand for a product varies
inversely with its price.
2.4
As the price of a commodity goes up then there is a fall in the quantity
which consumers are willing and able to buy. This happens for two
main reasons:
• The income effect. As the price of a good rises then a person’s real
income (i.e. their buying power) falls. They are not able to buy the
same quantity.
• The substitution effect. As the price rises then the marginal utility
per p of the last unit(s) consumed falls. The rational consumer would
switch to substitutes which would give a higher marginal utility per £
(better value for money). They are less willing to buy.
Remember from para 1.7 that a consumer will arrange his spending
until:
MU of last unit of good A
MU of last unit of B
=
Price of A
MU of last unit of C
=
Price of B
Price of C
If the price of apples were to rise then the MU per p gained from the
last apple would fall. The consumer would switch that spending to
bananas or chocolate until equality of MU per p was restored. By
consuming fewer apples the MU per p from the last apple will rise and
by consuming more bananas or chocolate the MU per p from the last
unit of these will fall.
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2.5
Exceptions to the Law of Demand
• Goods of prestige or ostentation, e.g. the demand for c ertain brands
of jeans, training shoes or cars may rise as their price rises.
• Assumption of link between price and quality – consumers may
equate a rise in the price of a product as meaning that its quality has
improved.
• Expectation of future price rises, e.g. speculators may react to a rise
in the price of shares by buying more, expecting them to rise even
further.
• Giffen goods – Giffen, a nineteenth-century economist, observed
that during the Irish potato famine, the demand for potatoes rose as
their price rose. This was because living standards were so low that
most people spent nearly all their income on potatoes, a filling food,
so that when the price rose they had so little money to buy meat, etc.,
that they bought more potatoes. This effect can apply to any basic
foodstuff in conditions of poverty.
The demand curve in any of the above situations will slope upwards but
note that above a certain price it will resume its normal shape, as the
income effect will reduce people’s ability to buy the p roduct.
Notice that the demand curve resumes its normal slope above a certain
price. This is because the income effect will come into force.
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3
Changes in conditions of demand
3.1
Ceteris paribus. One difficulty in economics is predicting the effect of
a change in a variable because there may be a number of different
causal factors. The economist’s way round this is to assume ceteris
paribus. ‘Ceteris paribus’ is a Latin phrase meaning other things
remaining the same. Ceteris paribus is assumed so that the effect of one
changing variable can be predicted.
Example
Price is only one of many factors which determines the demand for a
product – others include changes in income, prices of other goods,
population, etc. With all these conditions affecting demand, one cannot
predict a fall in demand as price rises unless these other conditions
remain the same. Ceteris paribus is therefore assumed in the Law of
Demand, i.e. the only changing influence is price, and all other
conditions which could cause demand to change have not changed. Of
course, in real life things are not so simple!
3.2
What are the conditions of demand? These are the factors, other than
the price of the product, which may cause demand to change. They
include:
• number of consumers (think of the effects of a change in total
population and of a change in age distribution)
• disposable income (think of the effect on normal goods and on
inferior goods)
• prices of other goods (think of complementary goods e.g. central
heating and gas, and of substitute goods, e.g. gas and electricity)
• tastes and preferences, e.g. the influence of fashion and advertising.
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3.3
Note the different ways of showing the effect of a change in price on a
demand curve and the effect of a change in a ce teris paribus condition.
A change in price is shown by a movement along the demand curve,
whereas a change in a condition is shown by a shift in the curve.
Change in price
Change in a demand condition
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4
Elasticity of demand
You need to know about two types:
• price elasticity
• income elasticity.
Note that when writing or talking about elasticity of demand you should
state what kind of elasticity of demand it is, i.e. price or income.
4.1
Price elasticity of demand (PED). This is a measure of the
responsiveness of demand to a change in price. Price elasticity
measures the reaction of consumers to a change in the price of a
product. It is measured by comparing the percentage change of demand
to the percentage change in price, i.e.
% change in demand
Price elasticity of demand =
% change in price
• If PED is greater than 1, i.e. if the % change in demand is greater
than the % change in price, then demand has been very responsive to
the change in price. Demand is said to be price elastic.
• If PED is less than 1, then demand is price inelastic.
• If PED is 0, then demand has not changed at all. Demand is perfectly
inelastic.
• If PED is equal to infinity (meaning that demand changed without a
price change) then demand is perfectly elastic.
• If PED =1, then demand has unitary elasticity. This means that the %
change in demand and the % change in price are the same.
Note that the value of PED will usually be negative because an increase
in price will cause a decrease in demand and vice versa. PED would
only be positive in cases where demand does not follow the normal law
of demand. This would be when demand increases as price rises (see
para. 2.5).
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4.2
Effects of price elasticity on sales revenue
Graph A
Graph B
Revenue gain
Revenue gain
Revenue loss
Revenue loss
Graph A shows that demand is price
inelastic. A rise in price from P to P 1
leads to a fall in demand from Q to Q 1 .
The % fall in demand is less than the %
rise in price. The revenue gained as a
result of the rise in price is greater than
the revenue lost as a result of the drop
in demand so that revenue rises. You
should also be able to say what would
happen to revenue if price fell.
4.3
Graph B shows that demand is price
elastic. A rise in price from P to P1
leads to a fall in demand from Q to
Q1. The % fall in demand is greater
than the % rise in price. The revenue
gained as a result of the rise in price
is less than the revenue lost as a result
of the drop in demand so that revenue
falls. You should be able to explain
what would happen to revenue if
price fell.
Factors affecting price elasticity of
demand
• Availability of substitutes. The closer the substitute the more
elastic is demand (the more responsive are consumers).
• Price relative to total spending. If low then consumers take little
notice of a change in price, e.g. the demand for a box of matches will
tend to be price inelastic – consumers will take little notice of a 10%
(1p or 2p) change in price.
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• Habit. The more a commodity is considered to be a necessity then
the more demand will be price inelastic, e.g. petrol, cigarettes, a
newspaper.
• Fashion. Products which are in fashion will tend to have a price
inelastic demand, e.g. certain brands of jeans, toys, hairstyles.
• Frequency of purchase. Products that have to be bought frequently
have price inelastic demands, e.g. fresh milk. Where purchase can be
postponed, e.g. consumer durables (TVs) demand tends to be price
elastic, in the short run at least.
4.4
The importance of price elasticity of demand
(a)
Businesses will want to know the effects on sales revenue if they
change their prices.
• raising the prices of goods that have an inelastic demand will
raise revenue
• lowering the prices of goods that have an elastic demand will
raise revenue.
Note that firms cannot predict exactly what will happen to
revenue since they cannot predict accurately the response of
consumers to a change in price, and of course ceteris paribus does
not exist in the real world.
(b)
4.5
Government will want to know the effect on tax revenue if they
change an expenditure tax. An increase in an expenditure tax
increases the price of a good. Whether revenue increases depends
on demand for the taxed product being price inelastic.
Income elasticity of demand
Income elasticity of demand measures the responsiveness of demand to
a change in income. It is calculated by:
% change in demand
% change in income
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MICROECONOMICS
If a person’s income rises by 10%, it does not follow that he will buy
10% more of all that he was previously buying.
4.6
24
(a)
Some commodities will still be out of his reach – 0 income
elasticity.
(b)
Some commodities he will buy no more or no less of, e.g. a
newspaper – 0 income elasticity.
(c)
Some commodities he may buy only a little more of, e.g. food –
income inelastic demand. The demand for necessities in a high income economy such as the UK tends to be income inelastic.
(d)
Some he may buy significantly more of, e.g. meals out,
entertainment – income elastic demand. Luxury goods/services
tend to have an income elasticity of demand greater than 1.
(e)
Some he may buy less of, i.e. inferior goods such as bread, cheap
brands of clothing – negative income elasticity.
The importance of income elasticity
(a)
If sellers know the income elasticity of demand for their products
they will be able to predict what will happen to their total revenue
in times of changing incomes, e.g. if demand for a product is
income elastic then in times of rising incomes sellers can expect a
significant rise in demand and in revenue. For products which
have an income inelastic demand then the rise in incomes will
increase demand but not by much – sellers can expect a small rise
in revenue. For inferior products which have negative income
elasticity demand then demand would fall and so would revenue.
On the other hand in a period of falling incomes, say in a
recession, the demand for inferior goods and services should rise.
(b)
The Government would also be able to predict changes in revenue
from taxes on products.
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MICROECONOMICS
Topic 3: Supply
The Nature of Production
1
Specialisation
Modern production is based on the principle of specialisation.
Specialisation is the use of a resource for that productive activit y for
which it is best suited. Resources are scarce, so it is desirable to use
them efficiently, i.e. to achieve maximum output from each resource.
Specialisation in the use of resources is a means of achieving
efficiency.
2
Benefits of specialisation
• increased productivity
• reduced unit costs of production
• efficient use of scarce resources.
3
Applications of specialisation
The concept of specialisation is applied at different levels of
production:
• At national level, countries specialise in different products, e.g.
copper, coffee.
• At regional level, regions of a country specialise, e.g. farming,
manufacturing industry.
• At industry level, specialisation takes place, e.g. whisky distilling,
car manufacture.
• At firm level, specialisation between firms occurs, e.g. whisky
distilling, barrel making, bottling.
• At worker level, where specialisation is called division of labour.
4
Division of labour
4.1
Advantages for the worker
(a)
(b)
(c)
(d)
Increased productivity – increased income.
Skill and dexterity are more easily acquired.
Worker can specialise in the job she/he is best at and which gives
the most satisfaction.
Opportunity of employment for workers of all abilities is
increased because out of the large variety of occupations, even the
least qualified will be able to do some simple task.
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4.2
Disadvantages for the worker
(a)
(b)
(c)
Increased risk of unemployment – a fall in demand for a worker’s
output will make him/her redundant. This risk increases the more
specialised and the less occupationally mobile the worker is.
Interdependence – each person is dependent on others in the
workforce; any break in the chain of production will have a wide
effect.
Monotony in certain repetitive jobs may lead to loss in
productivity through absenteeism, carelessness and spoiled work.
5
Production decisions in the short run and long run
5.1
Producers aim to maximise profit. One way of doing this is to seek the
most efficient method of production in order to keep cost of production
per unit to a minimum.
5.2
A distinction is made between the short-run period of time and the longrun. The distinction is not made in terms of days, weeks or months, but
in terms of how long it takes a firm to change its size. The size of a
firm is measured by its capacity. Capacity is the maximum output which
it could produce (its production possibility).
5.3
The short run is that period of time when the capacity of the firm is
fixed. At least one factor of production is fixed in quantity. This could
be the size of the building, the number of machines, the number of
skilled workers, etc.
5.4
The long run is that period of time when the capacity of the firm can
be increased or decreased. In the long run the size of the firm can be
changed.
5.5
The length of the short run varies from firm to firm and industry to
industry. A window cleaner could increase his capacity (by buying
another ladder and bucket, and employing another worker) very quickly.
An electricity-generating firm would take years to obtain planning
permission, commission a builder, and build and equip a new power
station.
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Section 6 is for Higher only
6
Production in the short run: the law of diminishing returns
6.1
Returns is a name given to what a producer gets back in output when
she/he employs more of a factor of production, e.g. returns to labour
means the output gained when more workers are employed.
6.2
In deciding what output is the most efficient to produce in the short run
a firm needs to consider the law of diminishing returns.
6.3
The law of diminishing returns states that if a producer uses more of a
factor of production when at least one of his other factors is fixed then
returns to the variable factor will increase at first, but diminishing
returns will eventually set in.
6.4
Illustration – serving meals in a school canteen
Assumptions
• Labour is a variable factor of production.
• All other factors of production, land capital and enterprise are fixed.
• Each worker is equally efficient.
• The state of technical know-how remains fixed.
Workers
0
1
2
3
4
5
6
7
8
Total output
(meals per
hour)
0
20
54
100
151
197
230
251
234
Marginal output*
(meals per hour)
Average output**
(meals per hour)
0
20
34
46
51
46
33
21
–17
0
20
27
33.3
37.75
39.4
38.3
35.9
29.25
* Marginal output is the extra output produced when an extra worker is
employed.
** Average output = total output ÷ no. of workers.
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MICROECONOMICS
You should draw:
(a)
(b)
6.5
a graph to show how total output varies with workers (workers on
the horizontal axis)
a graph to show how marginal output and average output vary
with the number of workers.
Observations
Total output
• Until the employment of the fourth worker, total output increased at
an increasing rate.
• Between the employment of the fourth and seventh workers total
output increased at a decreasing rate.
• After the employment of the eighth worker total output fell.
Marginal output
• Marginal output increased until the employment of the fourth worker
(there were increasing marginal returns).
• Marginal output decreased after the employment of the fifth worker
(there were diminishing marginal returns).
Average output
• Average output increased until the employment of the fifth worker
(there were increasing average returns)
• Average output decreased after the employment of t he sixth worker
(diminishing average returns).
6.6
Explanation
• Increasing Marginal Returns. When the second worker was
employed an extra 34 meals per hour were served. Total output did
not rise to 54 because one worker served 20 and the other served 3 4.
The two workers specialised and worked as a team to produce 54
meals.
• Diminishing Marginal Returns. After the employment of the fifth
worker, the additions to output fell because there was less
opportunity for further specialisation. When the eighth worker was
employed, there were so many workers that they got in each others’
way so much that output fell.
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7
Production in the long run: returns to scale
7.1
In the long run all factors of production are variable. A firm is able to
change its capacity, up or down. Changing capacity is also called
changing the scale of its operations or changing its size.
7.2
If a firm increases its scale by increasing the amount of resources it
uses, output does not necessarily increase in proportion. The
relationship between changes in output and changes in scale are called
returns to scale. There are three possibilities:
• Increasing returns to scale. Output may increase faster than the
size of the firm. In other words, the firm is becoming more efficient
as it grows in size. This is also called economies of scale.
• Constant returns to scale. Output may rise at the same rate as the
size of the firm. The firm’s efficiency remains unchanged as it
grows.
• Decreasing returns to scale. Output may rise more slowly than the
size of the firm. The firm is becoming less efficient as it grows
bigger. This is also called diseconomies of scale.
7.3
Economies of scale. Economies of scale occur when output rises faster
than the size of the firm, i.e. when there are increasing retu rns to scale.
Economies of scale may be of two types:
• Internal economies of scale are the improvements in productivity as
the firm grows in size.
• External economies of scale are the improvements in productivity
which a firm gains from the growth of its industry.
8
Internal economies of scale
These can be grouped under the following headings:
•
•
•
•
•
•
•
•
Technical
Financial
Purchasing
Managerial
Marketing
Research and development (R & D)
Risk bearing
Welfare.
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8.1
8.2
Technical economies of scale
(a)
Increased division of labour and specialisation – the larger the
firm the greater the opportunities for specialisation of men and
machines.
(b)
Increased dimensions – when any container is increased in size,
its volume increases by more than its surf ace area. This means
that its building cost per cubic centimetre falls as it increases in
size. This economy applies to all types of containers, e.g. storage
tanks, warehouses, ships, buses, aircraft. Savings will also be
made in labour, e.g. drivers, and in energy, e.g. fuel.
(c)
Indivisibility – the minimum size of some types of capital is large
and they can only be used efficiently by large firms with
sufficiently large outputs, e.g. a car assembly line, an oil -rig.
(d)
Principle of multiples – a production process often requires
several linked processes using different machines with different
capacities. For example, a process using three machines – A with
a capacity of 20 units per hour, B with a capacity of 30 units per
hour and C with a capacity of 40 units per hour – would require to
be producing at least 120 units to give a balanced team of fully
employed machines (6 A’s, 4 B’s and 3 C’s).
Financial. Large firms find it easier to:
(a)
(b)
8.3
attract investors from a wider variety of sources due to the lower
risk element and because they are more widely known.
borrow money at lower rates of interest.
Purchasing
(a)
(b)
Larger firms can negotiate larger discounts from buying in bulk.
Very large firms are able to dictate to their suppliers th e price,
quality and delivery date they want.
8.4
Managerial. Large firms can employ specialists because there is
sufficient work to fully occupy accountants, marketing managers, etc.
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8.5
Marketing
(a)
(b)
8.6
Research and development (R & D)
(a)
(b)
(c)
8.7
Large firms can afford costly research.
R & D enables innovation to take place giving firms a competitive
advantage.
Market share can be maintained or improved by product
development.
Risk bearing. Large firms can diversify:
(a)
(b)
(c)
8.8
Selling costs (advertising, salespeople’s salaries ) can be spread
over larger volumes of sales.
Transport costs per unit of sales can be lowered due to full lorry,
ship or train loads.
products to offset demand fluctuations.
markets – nationally and internationally to offset demand
fluctuations.
sources of supply to reduce risk of fluctuating prices and
availability.
Welfare. Large firms can afford to provide:
(a)
(b)
(c)
(d)
pensions
medical services
fringe benefits
recreational facilities.
All of these improve the motivation and efficiency of the workforce.
9
External economies of scale
These are particularly important when the firms of an industry
concentrate in a particular area.
Advantages may be gained from:
(a)
(b)
(c)
lower training costs because the concentration of the industry
justifies the existence of specialised facilities at a local college
ancillary services provided by specialist suppliers, e.g. transport,
materials, machinery, repairs
co-operation among firms.
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10
Diseconomies of scale
Increasing size may eventually bring inefficiencies and rising costs.
10.1 Internal diseconomies
(a)
(b)
Management problems – larger firms find it more difficult to keep
control of the activities of the organisation. Communication
through many layers of management becomes more difficult.
Waste is more difficult to detect and control, e.g. over -manning,
pilfering.
It is partly because of diseconomies of scale that in recent years many
firms have reduced their size (the jargon for this is downsizing). This
has been achieved by changing their management structures by
removing layers of management (known as delayering). They have also
reduced their size by contracting out work to other firms (known as
outsourcing) and laying off many of their staff.
10.2 External diseconomies. Growth of firms in an area may lead to extra
costs for those firms:
(a)
(b)
(c)
32
shortages of skilled labour and higher wage costs
shortages of raw materials
congestion and higher transport costs.
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MICROECONOMICS
The Costs of Production
1
Introduction
• Costs of production are the money values of resources used in
producing a good or service.
• Costs involve payments to those people who have provided the
resources, e.g. rent to a landlord, wages to workers, interest to a
bank.
• The owner of a firm may provide some of the resources, e.g. his/her
labour or capital. In calculating the cost of production the value of
the owner’s resources should be included as a cost. Since there may
not have been any money paid, the value of the resource is m easured
by its opportunity cost (what it could have earned in the next -best
occupation): e.g. if the owner could have got a job with another firm
as a manager earning a salary of £20,000, he should include as a cost
to his firm a salary of £20,000.
2
Normal profit as a cost
The owner of a firm will have provided enterprise. Enterprise is a factor
of production; therefore, the value of the enterprise is included as a
cost. The opportunity cost of enterprise – the profit which the owner
could have earned in another venture – is called normal profit. This
means that if the revenue earned is equal to cost of production then the
firm has earned a normal profit. If the revenue is greater than cost of
production, then the excess revenue is supernormal profit.
3
Definitions
• Fixed costs are costs which remain the same within a range of output
and they are incurred even when there is no output. Fixed costs are
also called overheads.
• Variable costs are costs which vary with output and are zero when
output is zero.
• Total costs are the sum of fixed costs and variable costs.
Total cost
• Average cost =
Output
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Average cost is sometimes called unit cost. Average cost may also be
calculated by Average fixed cost + Average variable cost
Fixed cost
• Average fixed cost =
Output
Variable cost
• Average variable cost =
Output
• Marginal cost (MC) is the extra cost of producing one more unit of
output, e.g. the marginal cost of the 50th unit of output is the total
cost of 50 units minus the total cost of making the first 49.
Marginal cost n = Total cost n – Total cost n–1
Since the costs which change with extra production are the variable
costs, marginal cost is the additional variable cost when one extra
unit of output is produced. Marginal cost can also be:
Marginal cost n = Variable cost n – Variable cost n–1
4
Short run and long run
4.1
The short run is that period of time when the capacity of the firm is
fixed. At least one resource is fixed in quantity. Some of the costs of
production will be fixed costs, e.g. the rent of the factory, the interest
payments and depreciation for the machines, the salaries of the
managers. The rest of the costs will be variable costs.
4.2
The long run is that period of time when the capacity of the firm can
be increased or decreased. In the long run, all costs are variable.
5
Short-run cost behaviour
See table on the following page.
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Output
(1)
0
1
2
3
4
5
6
7
8
9
Fixed
cost
(2)
£100
£100
£100
£100
£100
£100
£100
£100
£100
£100
Variable
cost
(3)
0
£100
£180
£230
£260
£350
£500
£670
£860
£1160
Total cost
Average cost
(4) = (2) + (3)
£100
£200
£280
£330
£360
£450
£600
£770
£960
£1260
(5) = (4)  (1)
–
£200
£140
£110
£90
£90
£100
£110
£120
£140
Average fixed
cost
(6) = (2)  (1)
–
£100
£50
£33
£25
£20
£17
£14
£13
£11
Average variable
cost
(7) = (3)  (1)
–
£100
£90
£77
£65
£70
£83
£96
£108
£129
Marginal cost
(8) = (4) or (3)
–
£100
£80
£50
£30
£90
£150
£170
£190
£300
You should draw
(a)
(b)
(c)
a graph to show how fixed cost, variable cost and to tal cost vary with output
a graph to show how average cost, average fixed cost and average variable cost vary with output
a graph to show how average cost, average variable cost and marginal cost vary with output.
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5.1
Total costs (see graph). When output increases in the short run then:
• Fixed costs do not change.
• Variable costs increase, but not necessarily at a constant rate.
• Total costs increase at the same rate as variable costs.
5.2
Average costs (see graph). When output increases then:
• Average fixed cost falls. This is because total fixed cost is the same
amount regardless of the volume of output. Total fixed cost is being
spread over an ever-larger output.
• Average variable cost falls until a certain output is reached and
then it rises. It falls because of improving efficiency and increasing
returns. It rises because of inefficiency efficiency and diminishing
returns. (For a fuller explanation of this, see the note on the law of
diminishing returns on p46).
• Average cost falls while average variable cost and average fixed
cost are falling. Average cost then rises when the increases in
average variable cost exceed the falls in average fixed cost.
5.3
Optimum output in the short run. The optimum output is the output
where the firm would be technically efficient. At this output, average
cost is at its lowest.
5.4
Marginal cost. Marginal cost falls and then rises as output increases.
There is a special relationship between marginal cost and average
variable cost:
• Marginal cost is less than average variable cost when average
variable cost is falling.
• Marginal cost is greater than average cost when average variable cost
is rising.
• Marginal cost is equal to average variable cost when average
variable cost is at its lowest, i.e. the MC curve cuts the AVC curve at
its lowest point.
A similar relationship exists between marginal cost and average cost.
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6
The short run and the law of diminishing returns
6.1
The law of diminishing returns explains what happens to marginal and
average cost as output is increased.
6.2
Diminishing returns and costs in the short run. Using the earlier
canteen illustration, assume workers are paid £4 per hour and that there
are no other variable costs.
Workers
Total
output
(per
hour)
Variable
cost
Marginal
output
per
worker
Average
cost
per
meal*
Average
output
worker
1
2
3
4
5
6
7
8
20
54
100
151
197
230
251
234
£4
£8
£12
£16
£20
£24
£28
£32
20
34
46
51
46
33
21
–17
20p
12p
9p
8p
9p
12p
19p
–
20
27
33
38
39
38
36
29
Average
variable
cost
per
meal
20p
15p
12p
11p
10p
10p
11p
14p
* Marginal cost per meal = marginal cost per worker ÷ marginal output
6.3
Observations
• Increasing marginal returns leads to falling marginal cost.
Diminishing marginal returns leads to rising marginal cost.
• Increasing average returns leads to falling average variable cost.
Diminishing average returns leads to rising average cost.
7
The firm’s output decisions in the short run
If we assume that firms aim to maximise their profits then how much
they will produce depends on the relationship between their sales
revenue and their costs.
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7.1
Revenue
• Total revenue is the total money earned from selling output, i.e.
quantity sold  price per unit.
• Average revenue = total revenue ÷ quantity sold. If a firm sells
only one product then average revenue is the same as selling price.
• Marginal revenue is the addition to total revenue earned when an
extra unit of output is sold. Marginal revenue is calculated by:
Marginal revenue n = total revenue n – total revenue n–1
7.2
When a firm can sell all its output at the same price, price and marginal
revenue will be the same.
7.3
The profit-maximising output in the short run. This can be
determined in two ways:
Method 1
Maximum profit is where the difference between total revenue and total
cost is greatest.
Method 2
This method involves making decisions on a unit-by-unit basis.
• If the extra cost (MC) of making an extra unit is less than the extra
revenue (MR), the firm will add to its profits by making and selling
the extra unit. The unit will be worth making.
• If the MC of an extra unit is equal to its MR, bearing in mind that
cost includes normal profit, it will be worth making a nd selling that
unit.
• If the MC of an extra unit exceeds its MR, making and selling that
unit would reduce the firm’s profit, so it would not be worth making.
A firm will maximise profit at the output where marginal cost =
marginal revenue. See diagram on next page.
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Marginal cost
Marginal
revenue
7.5
Shut-down position in the short run. A firm needs to make at least
normal profit in the long run to remain in an industry. In the short run
the firm will continue to produce as long as total revenue covers to tal
variable costs. Remember that in the short run, fixed costs have to be
paid, so if no output is produced and sold the firm will make a loss
equal to the fixed costs. As long as the revenue from an order covers its
variable cost it will be worth accepting since the money left after
variable costs have been covered can contribute towards the fixed cost
and so reduce loss. Therefore the shut-down condition in the short run
is when:
• Total revenue is less than total variable cost, or where
• Price is less than average variable cost.
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MICROECONOMICS
Marginal cost
Average variable cost
• At price P 1 the firm would shut down in the short run, as price is
less than AVC.
• At any price above P 2 the firm is more than covering its variable
costs and could use any surplus to help pay off i ts fixed costs. In this
way the firm minimises its loss per unit.
The firm’s supply curve
In the short run, the firm’s supply curve is the marginal cost curve
above average variable cost.
Applications of the shut-down price
In times of recession and falling prices there may be situations when a
firm is so short of trade that it has to consider shutting down by
mothballing plant and equipment.
Examples
• Oil producers facing low prices for crude oil. Many of the existing
oil reserves become uneconomic at low price levels and platforms
can be mothballed until market prices recover.
• Semi-conductor (microchip) plants were mothballed around the
world when prices collapsed because of stagnant demand.
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Costs in the long run
1
Introduction
In the long run all factors of production and costs are variable.
1.1
Economies of scale. Internal economies of scale are when a firm’s
average costs fall as the firm grows in size.
1.2
Diseconomies of scale. Increasing size may eventually bring
inefficiencies and rising average costs.
1.3
Average cost in the long run. As a firm increases its size, average cost
falls because of economies of scale. Beyond a certain size, average cost
may rise because of diseconomies of scale. The long -run average cost
curve is U-shaped. The long-run average cost curve encloses a series of
short-run cost curves joining them at their optimum points.
1.4
The point at which the firm achieves lowest average cost on the long run average cost curve would be the optimum size of the firm.
Short-run average cost
Long-run average cost
Optimum size
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Economies of Scale and Industry Structure
1
Introduction
In industries where the optimum size of a firm is small, i.e. where there
are few economies of scale to be gained, then those industries consist of
a large number of small firms. In industries where the optimum size is
large then there is likely to be a small number of large firms.
1.1
Where are small firms found?
• Where a market is small and there is insufficient demand for large scale production, then small firms will survive, e .g. luxury products
such as Porsche cars.
• Where a market is diversified, i.e. where customers want a wide
variety of choice then large-scale production is not possible. The
industry will consist of a large number of small firms, e.g. clothing,
footwear.
• Where a personal service is required then a small firm is more able
to deliver this. This explains why a large number of firms in the
service sector are small.
• Where it is easy for people to set up a business. This will be where
small amounts of capital are required or low-level technical
expertise. Again this explains why so many service firms are small.
1.2
Where are large firms found?
• where the market for the product is large – usually national or global
• where the demand is for a standardised product, i.e. where
consumers do not look for individuality
• where large amounts of capital are required
• where there is a need for substantial research and development.
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Multinational Enterprises
1
Introduction
In recent years there has been considerable growth in the number and
size of multinational enterprises. A multinational enterprise is a firm
which produces goods outside its country of origin. It does this in
branch factories or through subsidiary firms which it owns.
1.1
There are about 500 multinational companies in the world. Most are
American but the UK is the second most important country of origin. In
the UK, half of the top 20 companies are multinational. Some are
British, e.g. BP and Cadbury, and some are foreign. Most of the
incomers are from the USA, e.g. Ford and IBM, although there has been
a rapid increase in recent years from Japan, e.g. Nissan, Toyota, Sony.
2
Motives for overseas expansion
(a)
To reduce production costs
• by taking advantage of lower wage costs in some countr ies.
• by specialising internationally, i.e. producing different
components in those countries where they can be manufactured
most cheaply, e.g. Ford produces different components in
different countries.
• to spread the fixed costs of research and development over a
very large output, e.g. General Motors has a ‘world car’
concept, i.e. the same models are produced in different
countries (although they may have different brand names).
(b)
To reduce transport costs. Components may be cheaper to
transport than the bulkier finished article. Multinational
companies frequently reduce the cost of transportation by
transporting components from their countries of production to be
assembled in the country of sale.
(c)
To penetrate markets protected by import control s. A major
reason for the presence of US and Japanese firms in Europe is to
evade the tariffs imposed by the EU on goods coming from
outwith the EU.
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3
4
44
(d)
To take advantage of host-government financial assistance.
Many governments are keen to attract forei gn firms – various
incentives are offered, e.g. low-cost premises, grants, low-interest
loans, training subsidies.
(e)
To escape government regulations at home. Multinationals are
tempted to move if a government imposes restrictions, e.g.
minimum wage, anti-monopoly or minimum working conditions
regulations.
(f)
To earn higher after tax profits. This can be achieved by
moving production to countries with low profits taxes. (Transfer
pricing may also achieve this.)
Benefits of multinational companies
(a)
Trade – if investment by a multinational allows a host country to
produce more cheaply than other countries then imports will be
cut and exports boosted.
(b)
Employment – is created both in the multinational firm and in
firms asked to supply services and components.
(c)
New technology and management techniques are brought in.
These will be copied by other firms and lead to improved
efficiency, e.g. many UK firms have copied the efficient
management styles of Japanese and American firms.
(d)
Economies of scale – the large scale of operation enables the firm
to enjoy economies of scale and to be efficient – workers share in
this, e.g. employees in multinationals in the UK earn on average
20% more than those in domestic firms.
Problems with multinational companies
(a)
Trade – imports may increase if a multinational imports its
components, e.g. Ford imports 40% of the cars it sells in the UK.
(b)
Employment – in some cases the jobs created are low-skill
assembly jobs, the high-skilled research jobs being kept in the
country of origin. The management jobs are often taken by people
from the home country.
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(c)
Financial transfers – profits are transferred out to be
the shareholders in the home country.
(d)
Conflict of interest with host government
spent by
• in developing countries, multinationals may dictate the
growing of a particular raw material at the opportunity cost of
food crops.
• tax avoidance robs a government of funds to finance public
services.
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Supply
1
Introduction
Supply is the quantity of a good or service that firms are able and
willing to supply at a certain price over a certain period of time.
1.1
As with demand, a distinction is made between:
• an individual firm’s supply, which is the quantity of the good that
the firm is willing and able to supply at a certain price; and
• market supply, which is the total quantity of the good that all firms
in the market would be willing and able to supply.
2
Supply and output may not be the same
In a particular period, output may be greater than supply, i.e. stocks are
being increased, or output may be greater than supply, i.e. stocks are
being run down.
2.1
Stocks may be built up in readiness for unexpected or urgent orders, or
to even out the need for seasonal fluctuations of outpu t, e.g. fireworks,
ice cream. However, holding stocks involves costs – warehouse costs,
opportunity cost of capital tied up in stocks, loss of goods through
deterioration or obsolescence.
3
Factors affecting supply
3.1
Price. As the price of a product rises its supply rises (ceteris paribus).
This is because:
(a)
(b)
existing producers are willing to supply more as they earn a
higher profit per unit and,
new firms enter the market as it now becomes profitable for less
efficient firms to produce.
Price and supply data may be shown in a table:
Price per pint
£1.10
£1.50
£1.80
£2.00
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Quantity supplied per day (pints)
10,000
20,000
30,000
40,000
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or in a graph:
Note that a change in supply resulting from a change in price is sho wn
by a movement along the supply curve.
3.2
Prices of other commodities
• Competitive supply – a farmer switching resources away from
supplying one product, e.g. milk, to supplying more of another, e.g.
wheat, in response to a fall in the price of mil k
• Joint supply – a rise in the price of one commodity may encourage
an increase in its supply and the supply of joint products, e.g. an
increase in the price of petrol may lead to an increase in the supply
of other oil products such as bitumen, etc.
3.3
Costs of production
• A fall in the cost of any factor of production will lead to an increase
in supply.
• A change in a tax or subsidy will also change the costs of
production.
3.4
Change in availability of resources
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3.5
Note that any of the changes (in the ceteris paribus conditions) outlined
in paragraphs 3.2 to 3.4 is represented by a shift in the supply curve.
Change in supply condition
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Higher only
4
Price elasticity of supply
Price elasticity of supply is a measure of the responsive ness of supply
of a good or service to a change in its price, i.e. it measures how
suppliers react to a change in the price of their product.
% change in supply
Price elasticity of supply =
% change in price
If price elasticity is greater than 1, then supply is price elastic. Supply
is very responsive to a change in price.
If price elasticity is less than 1, then supply is price inelastic. Supply is
not responsive to a price change.
If price elasticity is zero, i.e. if supply did not or could not change in
response to a price change, then supply is said to be perfectly inelastic.
4.1
Factors affecting elasticity of supply
Time
The length of the time period being considered has an important effect.
Short run
(a) In the very short run, if a firm is operating at full capacity it will
be unable to respond to an increase in price. Supply will be
perfectly inelastic. The supply curve would be a vertical straight
line.
(b)
If the firm has spare capacity and stocks then it will be able to
increase supply. The more spare capacity or the more goods it has
in stock then the more elastic will be its supply.
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Long run
In the long run, supply will be elastic. Firms have time to increase their
capacity and new firms can enter the industry.
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Topic 4: The Operation of Markets
1
What is a market?
1.1
A market is formed when buyers and sellers of a good, service or
resource come in contact with each other in order to agree a price and
exchange.
1.2
The concept of a market in economics goes beyond the idea of a place
where people meet to buy and sell goods. Any arrangement where
buyers and sellers are in contact to exchange a product is a market.
Markets may be worldwide, e.g. oil, wheat, cotton and copper when a
single world price may be established, others may be more localised,
e.g. the housing market when prices for a similar house will vary from
area to area.
1.3
Markets exist for:
•
•
•
•
goods, e.g. cars, houses
services, e.g. bus travel, haircuts
resources, e.g. labour, land, raw materials
money, e.g. credit, foreign exchange.
Each of these markets has common features, i.e. something to be
exchanged, buyers, sellers and a price. Price may be known by different
names, e.g. bus fare, wage, rent, interest, exchange rate but all are
determined in similar ways.
1.4
Suppliers are usually firms but may in some markets be individual
citizens, e.g. car boot sales or local government departments, e.g.
council housing or central government, e.g. prescribed medicines.
1.5
Buyers may be individual citizens or households in the case of
consumer products, firms who buy raw materials, machinery or labour
and government who buy the supplies needed to provide services.
2
Free market
A free market is one where:
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• there are no barriers to firms competing with each other
• the price is set in the market by the total demand and supply; firms
have to accept this, i.e. they are price takers not price makers
• there is no government intervention.
3
Equilibrium price
In a free market an equilibrium price will be established. At the
equilibrium price:
• Quantity demanded by consumers is the same as quantity supplied by
suppliers.
• The market is cleared, i.e. there will be no unsatisfied customers
(shortages) and there will be no unsold supplies (surpluses). This is
why the equilibrium price is also called the market clearing price.
• The price will not change unless there is a change in demand or
supply conditions.
52
(a)
At a price of P 1 this market is not in equilibrium. Suppliers are
willing to supply B, and consumers are willing to demand A;
therefore, there would be a surplus of AB. Suppliers will react to
the unsold stocks by cutting production and reducing price.
(b)
At a price of P 2 , suppliers are willing to supply C and consumers
are willing to demand D; therefore there would be a shortage of
CD. Consumers will compete with each other for the available
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quantity by offering to pay a higher price and suppliers will
supply more.
(c)
4
At a price of P, there is no upward or downward pressure on price.
The market is in equilibrium.
Changes in demand conditions
• a rise in demand (D curve shifts to the right) leads to a rise in
equilibrium price and in the quantity exchanged in the mar ket.
• a fall in demand (D curve shifts to the left) leads to a fall in
equilibrium price and in the quantity exchanged.
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Note that the extent of change in price and quantity is affected by the
elasticity of supply. The more supply is elastic then the less will be the
change in price, but the more will be the change in quantity exchanged.
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5
Changes in supply conditions
(a)
An increase in supply (S curve shifts to the right) leads to a fall in
equilibrium price and a rise in the quantity exchanged.
(b)
A fall in supply (S curve shifts to the left) leads to a rise in
equilibrium price and a fall in the quantity exchanged.
Note that the extent of change depends on the price elasticity of
demand. The more demand is elastic then the less the change in price
but the more the change in the quantity exchanged.
6
Intervention in free markets
Governments may intervene in markets to alter the price or the quantity
exchanged. (This topic is also dealt with in Unit 2, The UK Economy,
Topic 4, under Market Failure and Government Policies.)
6.1
Governments may intervene in a market by:
•
•
•
•
•
setting a minimum price
setting a maximum price
imposing tax
giving a subsidy
setting a quota.
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6.2
Minimum price above equilibrium. Governments may do this because
they feel that the equilibrium price is too low. However, it may create
the problem of surpluses as is shown by AB in the following diagram.
Two examples of this include:
• Setting of minimum prices for farm products by the EU. This was
done to ensure that farmers got a decent income. However, it has
created the problem of surpluses and what to do with them. A
number of options is possible. The EU buys the surplus then stores
it, or gives it away as aid to the third world. To prevent surpluses the
EU has set production quotas for some products, i.e. limits to what
farmers should produce.
• Setting a minimum wage for low-paid workers. Critics said that
this would create unemployment, i.e. surpluses of workers, although
in practice this has not happened, as the introduction of the minimum
wage coincided with a rise in demand for labour.
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6.3
Setting a maximum price below equilibrium, because they feel that
the equilibrium price is too high. Governments have done this in o rder
to help low-income consumers or as part of an anti-inflation strategy.
Fixing prices below equilibrium may create black markets to which
black marketeers will divert supplies at a price above the official price.
In the diagram consumers demand B but can only get A. For quantity A,
consumers are willing to pay Z. This sort of intervention and effect was
common in planned economies such as the Soviet Union. This explains
the scenes of long queues at shops for bread, etc. Governments may
counteract a black market by rationing – by issuing coupons of
entitlement to each family so that each family has a fair allocation.
Rationing was used in the UK during and after the Second World War
when supplies were restricted.
6.4
Imposing expenditure taxes. A tax on expenditure has the same effect
as increasing the cost of production, since the suppliers have to pay it to
the government. Producers will raise their selling price to recover this
increased cost, although they may absorb part of the c ost by taking a
reduced profit.
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• Tax of EG. Supply curve moves up vertically by EG. Of the tax,
consumers pay EF, i.e. price goes up from P to P 1 and the producer
pays FG out of his profit.
• Share of the tax burden depends on the prop ortion which the supplier
can pass on to the consumer, which in turn depends on how
responsive the consumer is to an increase in price. If the supplier
believes that consumers will not cut their demand significantly, i.e.
if demand is price inelastic, then more can be passed on.
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6.5
Subsidies have the opposite effect to taxes. Subsidies are given to
encourage supply and keep prices low, e.g. rural bus services. Costs of
production are reduced and the producer may pass this on to the
consumer by lowering price. The extent to which it is passed on
depends on the price elasticity of demand. The more demand is price
inelastic, the more will be passed on. In the following diagram, XZ is
the subsidy, the consumer benefits by XY and the supplier gains by YZ.
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6.6
Quotas. Government may intervene to set a maximum quantity which
can be supplied to a market. An example is the total allowable catch by
UK fishermen of white fish (cod, haddock). This yearly quota has been
fixed to try to conserve white fish stocks. Economic analysis would
suggest that the price of white fish would rise. This has not happened to
any great extent because some fishermen have been catching above the
quota and selling on the black market to processors. (Hence the term
black fish.) Supply has also been boosted by imports.
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Topic 5: Types of Market
This topic is for Higher only
1
Introduction
Markets are of two main types; perfect and imperfect. Perfect markets
do not exist in the real world but some markets are closer to this perfect
model than others, e.g. some agricultural products. It follows then that
most markets are imperfect.
2
Perfect markets
A perfect market is assumed to have the following characteristics:
3
(a)
Large number of firms. No firm is big enough to influence price.
Firms are price takers, i.e. they have to take the price which is set
in the market.
(b)
Large number of buyers. No one buyer is big enough to
influence price.
(c)
Freedom of entry and exit from the industry. There are low
barriers to entry. Struggling firms can leave the industry quickly
and easily.
(d)
Perfect knowledge. All consumers and producers know the price
being charged by every producer so that if one producer increased
his price the demand for his product would fall t o zero.
(e)
Homogeneous product. The output of each firm is identical and
there is no branding or product differentiation.
Imperfect markets
An imperfect market is any market which does not have any one of the
characteristics of a perfect market. There are different types of
imperfect market depending on the extent of competition within them.
The extent of competition depends on the number and size of suppliers
and buyers within the market. There are four types of imperfect market:
• monopoly
• oligopoly
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• monopolistic competition
• monopsony.
3.1
Monopoly. In a monopoly market, there is only one firm. The strength
of its monopoly position is determined by the strength of barriers to
entry to new firms and the availability of substitutes. A mono poly may
exist in a national market, e.g. the Post Office with letter post, or in a
local market, e.g. a village shop. Monopoly gives the sole supplier
power to charge above normal price, restrict supply or generally not
bother too much about improving the product or quality of service. Note
that the monopolist cannot charge ‘whatever price it likes’ – there is a
limit to what consumers are able or willing to pay!
Because of the power which monopoly gives a supplier the Government
may investigate a monopoly, or a merger which may lead to monopoly,
and it may order the break-up of a monopoly or stop a merger taking
place. Government also recognises that in some industries monopoly
may be the most technically efficient structure because of the
economies of scale which can be gained, e.g. Railtrack, Transco. In
such cases the Government allows the monopoly, but has the power to
regulate prices and quality of service. (Monopoly regulation is covered
in more detail in Unit 2, The UK Economy, Topic 4.)
3.2
Oligopoly. This is a market dominated by a few large firms. It is a
common market structure, and examples include soap powder (where
Procter & Gamble and Unilever each have over 40% of the market),
burgers (dominated by McDonalds and Burger King), and petrol. (A
two-firm oligopoly, such as in the market for salt or soap powder, is
sometimes called a duopoly.)
Each firm is large, has branded or differentiated products and has a lot
of influence in the market to affect its own and its competitors’ market
share. However, each firm is aware of the potential strength of
competitors and as a result must predict their reactions before it makes
any decision about changing its own product, price, or supply.
To expand or maintain market share in an oligopoly market, firms tend
to use non-price methods, e.g. advertising and branding, rather than
price competition because price competition involves costly price wars.
Firms may even collude (make agreements) to
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fix prices, limit output, or agree to share out the marke t. This is now
illegal.
Barriers to entry exist to limit easy entry of new firms.
3.3
Monopolistic competition. There are a large number of firms but each
firm produces a branded or differentiated product. This gives each firm
some control over the price it can charge and over its market share.
There are weak barriers to entry. Examples include hairdressers,
restaurants.
3.4
Monopsony. A monopsony is a market where there is only one buyer.
This gives the buyer the power to dictate price, product design ,
delivery, etc. to the supplier or suppliers. The supermarket and fast food chains are so large that they have a degree of monopsony buying
power over many suppliers who are almost entirely dependent on their
custom.
4
Product differentiation
With product differentiation, suppliers try to create differences between
their products and the products of others. These differences might be
real, e.g. product design, quality of service; or imaginary, created by
packaging, advertising and brand image, e.g. ‘des igner labels’.
5
Barriers to entry. Barriers to entry prevent potential competitors from
coming into an industry. Barriers to entry may be deliberately set up by
existing firms or they may be natural.
5.1
Deliberate barriers to entry
• Marketing barriers. High spending on advertising and marketing
creates a powerful brand image and sense of brand loyalty in the
minds of the consumer, e.g. washing powder, breakfast cereals.
• Restrictive trade practices. A restrictive trade practice is a strategy
used by a firm to restrict competition in its market.
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Examples
• A manufacturer may refuse to sell to a retailer which buys the
products of a rival (common in the market for beer).
• A manufacturer may refuse to sell a good unless the buyer buys its
whole range of goods (also common in the alcohol market).
• A firm may engage in predatory pricing, i.e. cut prices to customers
in the whole of its market, or in the part of the market where
competition is strongest, for just long enough to drive out a new
entrant. Large firms may be able to do this because of their ability to
cross-subsidise from customers or from products where there is less
competition. Aberdeen Journals were found guilty of such an offence
in trying to drive a free advertising newspaper ou t of business and
were fined £1million.
5.2
Natural barriers to entry
• Capital costs. Entry costs to some industries are very high, e.g. cars,
steel. The vast amounts of capital required to set up prevents new
firms from entering.
• Sunk costs. These are costs which cannot be recovered if the firm
folds. High sunk costs such as advertising or research and
development deter new firms from taking the risk of entering an
industry and failing, e.g. washing powder, cars.
• Economies of scale. In some industries where a few firms are very
large and enjoy considerable economies of scale it will be difficult
for a new firm to break in and compete with the low average cost.
• Legal barriers. The law gives some firms particular privileges.
Patents (e.g. to drug companies) and copyrights (e.g. to software
publishers) give certain firms exclusive rights to produce or publish
certain products. Licences may be given to TV companies, bus
companies or airlines to operate exclusively in certain areas or on
certain routes (but note that there has been considerable deregulation
in recent years).
6
Pricing in markets
6.1
Perfect markets. In perfect or near-perfect markets the price of the
product is determined by the interaction of market demand and market
supply. Each firm has to accept this market price – each firm is said to
be a price taker. The price of coffee, cotton, wheat, etc. is established
in the world market and individual farmers have to accept this price.
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6.2
Imperfect markets. In imperfect markets, firms adopt a range of
pricing strategies and the decision as to which strategy to choose is
based upon the competition facing the firm. Pricing strategies fall into
two groups – cost-based pricing and customer-orientated pricing.
6.3
Cost-based pricing
Cost-plus pricing
Price is set by calculating the average cost of production and adding a
mark-up for profit, e.g. average cost £5 plus mark -up of 20% would
give a price of £6. Firms that have little competition can use cost -plus
pricing.
Advantages
• quick and easy method
• ensures sales revenue will cover total costs and make profit.
Disadvantages
• fixed mark-up could be a problem if new competitor(s) were to enter
the market.
Contribution (marginal cost) pricing
Price is set to cover the variable costs of production. So as long as price
more than covers variable cost a contribution is being made towards the
fixed costs. If the firm receives enough orders so that contribution
equals fixed cost then the firm breaks even. If contribution exceeds
fixed costs then profit is made.
Advantages
• more flexible than cost plus – successful products can be priced to
make a large contribution, less successful products can be priced
more competitively.
• pricing of products can take account of competitors’ prices and
consumer demand.
• can be used during poor trading conditions when firms may have to
accept prices at below cost – as long as variable costs are covered
then a contribution can be made to the fixed costs which have to be
paid, thus reducing loss.
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6.4
Customer-orientated pricing
• Competition-based pricing. Many firms operating in imperfect
markets still face strong competition, e.g. monopolistic competitive
markets. In such markets, there are many competitors and firms are
forced to take the market price and work out how to produce at cost
that gives them an acceptable profit. Prices charged by competitors
are the main influence on a producer’s price. In oligopoly markets,
even where there are only a few firms, it is common for competitors
to charge the same price. One firm becomes the price leader and
others follow, e.g. petrol. This avoids costly price wars.
• Penetration pricing. New entrants to a market may set prices below
those of present suppliers in order to gain a foothold in the market.
Consumers are encouraged to develop the habit of buying the product
so that when prices eventually rise they will continue to buy.
• Predatory pricing. This is a method used by a firm to force out a
new entrant. An established firm may be able to reduce its pri ce to
such a low level that the new entrant cannot cover its costs. The
established firm can cover its losses out of reserves or by cross subsidising from other products.
Firms may use the following pricing methods in short -term or long-term
monopoly situations:
• Charging what the market will bear. Suppliers of products which
are unique may charge the highest price which they think consumers
are prepared to pay.
• Skimming pricing. Suppliers of new products may charge a high
price for a limited period in order to maximise revenue before
competitors come into the market. It is also used by firms whose
products have a short life, e.g. toys, fashion clothes.
• Psychological pricing. Products may be priced above the existing
competition to create the perception of better quality, e.g. Haagen Dazs, Stella Artois. The success depends on the consumer believing
this.
• Price discrimination. This is when a firm offers the same product at
different prices to different consumers. The success of price
discrimination depends on the consumers paying the cheaper price
being unable to sell to those paying the higher price. This strategy is
quite common – think of package holidays, air and rail fares,
telephone calls.
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